The Greenback and Commodity Prices

This article appeared in the September 2008 issue of Globe Asia.
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The Federal Reserve's modusoperandi is to panic at the sightof real or perceived economictroubles. As long as inflationremains at, or below, its "targetlevel", the Fed provides emergencyrelief. It does this by pushinginterest rates below where themarket would have set them.

With interest rates artificially low, consumersreduce savings in favor of consumption, andentrepreneurs increase their rates of investmentspending. In consequence, an imbalance betweensavings and investment occurs and the economy is pushed ontoan unsustainable growth path.

Back in 2002, productivity in the US was in a boom phaseand inflation was decelerating. For economists of the Austrianschool, this was good news. Indeed, it appeared that the USmight have both strong real growth and a mild deflation. FormerFed Chairman Alan Greenspan didn't see it that way. Hewas convinced by current Fed Chairman (then Governor) BenS. Bernanke that "we face new challenges in maintaining pricestability, specifically to prevent inflation from falling too low."

In the face of a possible deflation, the Fed panicked andstarted pushing interest rates down. By July 2003 the Fed fundsrate was at a record low of 1%, where it stayed for a year.

This set off the mother of all modern liquidity cycles, and,as members of the Austrian school anticipated, a credit boomthat ended badly.

The super-low Fed funds rate also resulted in a rout of theUS dollar. For example, from 28 December 2001 until 11 July2008, the greenback shed 44% of its value against the euro.Commodity prices exploded during this period, with the CommodityResearch Bureau's index increasing by 122%.

And why not? After all, when the value of the dollar falls,the nominal dollar prices of internationally traded commodities- most being priced in dollars - must increase from wherethey would have otherwise been, because more dollars are requiredto purchase the same quantity of any commodity.

Counter-factual

The fed has repeatedly kicked the weak dollar/strongcommodity price story into the tall grass. For example, FedVice Chairman Kohn had this to say at a conference on May20th: "In sum, lower interest rates and the reduced foreign exchangevalue of the dollar may have played a role in the risein the prices of oil and other commodities, but it probably hasbeen a small one."

And when presenting his Semi-annual Monetary Policy Reportto Congress on July 15, Fed Chairman Bernanke repeatedthe standard Fed line, namely that the weak dollar might haveonly contributed "somewhat" to commodity price inflation.

To examine the link between the greenback and commodityprices, a counter-factual – a 'what if' thought experiment– is well suited.

Counter-factuals are often employed to examine alternativesto actual history. For example, what would have happenedif, contrary to fact, some present condition were changed?

The use of counter-factuals has a rich, if not controversial,history. Perhaps the most famous counter-factual was employedby Professor Robert Fogel of the University of Chicagoin Railroads and American Economic Growth.

In that book, Professor Fogel calculated what the transportationsystem of the United States in 1890 would have lookedlike without railroads. His calculations created a great controversybut they were robust and helped him win the 1993 NobelPrize in Economics.

Table 1 contains the results of counter-factual calculations.By computing what the prices of various commodities wouldhave been on 11 July 2008, if the US dollar-euro exchange ratewould have remained the same as it was on 28 December 2001,we can determine (on a counter-factual basis) what the exchangerate (weak dollar) contribution to the total change invarious commodity prices has been since 2001.

For example, rough rice prices have increased by 385% since2001, and the weak dollar has contributed 55.53% to the priceincrease of rough rice. In the case of rough rice, real factors(supply and demand fundamentals) have also contributed tothe price increase since 2001 - namely 44.47%. This is signifiedby a "+" sign in the last column of Table 1 for rough rice.


Contribution of the Weak Dollar
to Commodity Price Increases (28-Dec-2001 to 11-Jul-2008)

Contribution of the Weak Dollarto Commodity Price Increases (28-Dec-2001 to 11-Jul-2008)

The following is the computation for the weak-dollarcontribution to the price increase of rough rice.

Price of Rough Rice on 11-Jul-08 if the USD/EURO exchange rateremains at 0.8912 (28-Dec-01)
= 1,790 x 0.8912 / 1.5938 = 1000.91

Total Change on Rough Rice Price from 28-Dec-01 to11-Jul-08
= 1,790 - 369 = 1,421

Exchange-rate Contribution to the Change in the CommodityPrice
= 1,790 - 1,000.91 = 789.09

Exchange-rate Contribution as a Percentage to TotalChange in Price
= 789.09 / 1,421 = 55.53%

Note: *The percentage represents the U.S. dollar depreciation from 28-Dec-01 to 11-Jul-08Source: Commodity Research Bureau, "Components: Monthly Charts and Data"; Bloomberg; and author's calculations

Lean hogs are at the other end of the spectrum. If the dollar-euro exchange rate would have remained at its 28 December2001 level, the price of lean hogs would have declined from57.05 cent/lbs. to 41.74 cent/lbs. during the 28 December 2001- 11 July 2008 period. In fact, the price of lean hogs was 74.65cents/lbs. on 11 July 2008.

Changes in the Value of the Dollar and Commodity Prices (11-Jul-2008 to 11-Aug-2008)
Contribution of the Weak Dollarto Commodity Price Increases (28-Dec-2001 to 11-Jul-2008)

Note: *The percentage represents U.S. dollar appreciation from 11-Jul-08 to 11-Aug-08 **The percentage represents CRB Index decline from 11-Jul-08 to 11-Aug-08 Source: Bloomberg; and author's calculations

Accordingly, the exchange-rate contribution to the changein the price of lean hogs since 2001 was 186.98%. This contributionexceeds 100% because real factors were working to depressthe price of lean hogs, and that is why a "–" sign is enteredin the last column for lean hogs.

Given the dollar's recent upward surge in value, we don'thave to rely solely on a counter-factual thought experiment toshow how nonsensical "Fedspeak" can be. As Table 2 indicates,the dollar has appreciated against the euro by 6.9% during the11 July -11 August 2008 period.

With the exception of live cattle and lean hogs, the pricesof all commodities listed have fallen. And the CRB Foodstuffsand Spot indexes have fallen by -7.12% and -6.31%, respectively,during the period in question. That's almost a perfect mirrorimage of the dollar's strength.

For investors, the lesson is clear: you must take official explanationswith a dose of salt and think things through on yourown.

Steve H. Hanke

Steve H. Hanke is a professor of applied economics at Johns Hopkins University in Baltimore and a senior fellow at the Cato Institute.